Portugal Sets Aside Cash Against Derivatives

By Anousha Sakoui and Peter Wise, Financial Times

Wednesday, 28 Jul 2010 | 3:36 AM ETFinancial Times

SHARES

Portugal has become the first euro-zone country to agree to set aside cash – or other assets – against derivative transactions in a decision intended to reduce its funding costs. Banks regularly post collateral in derivatives trades in order to protect the other party in the event that a deal were to be be unwound when it is trading at a loss. But sovereign borrowers typically do not post collateral.

Davis McCardle | The Image Bank | Getty Images

Portugal

Posting collateral could help countries by lowering the costs banks charge them for derivatives, for example in hedging against currency or interest rate moves.

That, in turn, could potentially lower volatility and prices in sovereign credit default swaps (CDS), say bankers, which should have a positive effect on their borrowing costs.

Long running talk of sovereigns putting up cash, or other assets, in swap agreements with banks have been closely watched by bankers and regulators seeking to reduce counterparty credit risk in the derivatives market, in the wake of the global financial crisis.

Borrowers in debt markets, whether companies or countries, often use interest rate or currency derivative swaps to manage their finances.

These agreements can move into profit at any point in time for either side of the transaction, depending on the shifts in the market. By posting collateral, the risks are reduced for the party on the other side of the transaction.

One country which does at present post collateral in derivatives trades is Sweden.

Bankers said Portugal’s decision has potentially broader implications, as many supranational borrowers and agencies also do not post collateral.

“Portugal’s decision is very significant for the market,” said John Wilson, global head of over-the-counter clearing at Royal Bank of Scotland. “This move has been in the pipeline for a while. Since the credit crisis the standard practice that sovereigns, as well as supranationals and agencies, do not take credit risk against banks by refusing to post collateral has started to impact their funding costs.”

“I expect other countries that have greater funding problems will also agree to collateralize their swaps,” he said.

In the wake of the financial crisis, banks have had to charge borrowers more for these swaps. And with the intensifying sovereign debt crisis in Europe this year, the cost of these swaps has risen so high as to become, in some cases, prohibitive for countries to enter into, said one banker.

When there is no collateral to protect the banks’ position, some banks have been using CDS to hedge the risk of the sovereign borrower defaulting. That, in turn, has been leading to elevated CDS prices to which sovereign funding costs are linked.